A “Quality” Quality Factor

Abstract

This article examines the concept of quality as a factor commonly used in portfolio management. Although value and momentum are fairly well-established constructs, the third major factor in many models, quality, is not so well articulated. This research aggregates the most common components of quality into a parsimonious, well-defined factor (QAL) using the data reduction technique known as partial least square. The authors show that their factor has power independent of the other factors and significant return in excess of common risk models. Moreover, their QAL factor possesses favorable downside risk properties and works as a superior hedge during turbulent market performance periods, which they contend is the main feature one would expect of assets with high quality. Additionally, adding the authors’ QAL to an opportunity set consisting of other factors, as well as a traditional 60/40 equity/fixed-income portfolio, increases the Sharpe ratio and improves downside protection simultaneously because of its diversifying effect.